Tier I & Tier II Bonds
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Basel 3 is an internationally agreed set of measures designed by the Basel Committee. It is a continuation of Basel 2 which primarily focused on capital levels. Basel accords were designed in response to 2007-09 financial crisis and in order to mitigate the risks associated with lending.
Basel 3 Compliances:
Risk Weighted Assets
While practicing the business of lending any financial institution is required to set aside a specific proportion of their capital as a buffer to deal with financial shocks.
Financial institutions are required to weigh the risks associated with their lending portfolio – it could be any proportion and is measured by keeping in mind various elements. For instance, if the risks weighted could be 100% or 50% or only 10% of the loan amount. After weighing each loan, the total risk weighted assets. Basel 3 implies that at least 7% of the risk weighted asset should be set aside for mitigating the risk of lending. This proportion could differ based on the nature of activities of each institution.
Balance Sheet
As per Basel 3 compliance, banks are required to limit and/or reduce the size of their balance sheet. The scale of operations a bank can develop is limited in comparison with its own capital, this is controlled by the leverage ratio.
Liquidity
Basel 3 accords imply that a bank needs to manage and maintain sufficient liquidity in order to provide a cushion at times of stress. Each bank needs to maintain equilibrium between its deposits and loans. During a period of 30 days of stress events, banks are required to maintain their liquidity at sufficient levels.
Bonds Under Basel 3:
Under Basel 3, capital is divided into two parts – tier 1 and tier 2 capital. While tier 1 is the primary capital constituting of equity, disclosed reserves and additional tier 1; tier 2 is supplementary and includes undisclosed reserves and unsecured subordinated debt with an original maturity of 5 years. Tier 1 and 2 together make up the total capital of a bank and need to be maintained as per the required norms measured by Capital Adequacy Ratio.
Tier 1 Bonds:
Both Tier 1 and Tier 2 bonds have a loss absorption features but this feature is relatively higher in Tier 1 bonds as compared to Tier 2. They are served by early warning indicators due to which Tier-1 bonds can bail out depositors as well as investors. Since the loss absorption characteristics are higher in Tier 1 bonds, they are considered to be riskier.
Pros:
Considering the risks in Tier 1 bonds, they are often offered with higher interest rates, if an investor analyzes the issuer’s financial health well before investing, they can earn handsome returns.
Since the issue is perpetual in nature, these bonds come with a step-up option. Step up option links the instrument’s interest rate with its credit rating, with every notch down – the interest rate is increased by a pre-
specified proportion. However, if the ratings are upgraded, step down comes in play.
Risks associated with Tier 1 Bonds:
They can be permanently written off or converted into equity shares either in case of the capital ratio of 5.5% has been breached (for bonds issued before Mar’19) or the capital ratio of 6.125% has been breached (for
bonds issued post Mar’19).
They’re perpetual in nature with a call option available but not compulsory. Due to this, investors may be left with the option of selling these securities in the secondary market to get their principal back which
means that they have to depend on the securities liquidity in the
secondary market.
Tier 1 bonds are subject to a lock in clause. If the bank doesn’t have positive earnings in a particular year and the Tier 1 capital is below 8%, investors may not receive interest during that year. Coupons cannot be
paid out of retained earnings or reserves hence if the payment of coupons results in an overall loss – declaration of interest can be ruled out.
Additional Tier 1 Bonds
AT-1 Bonds are hybrid instruments and provide higher interest rates in line with higher risks associated with them. The biggest upside of these bonds are the attractive interest rates while the downsides are many.
Risks associated with AT-1 Bonds:
AT-1 bonds carry no maturity date and are perpetual in nature. They come with a call option that allows banks to redeem them after 5-10 years, however, banks are not obliged to use this option.
If under any circumstance the bank’s capital ratios falls, the face value of AT-1 bonds can be reduced to keep the borrowing in line with the regulatory requirements. Also, during any such year banks can opt out
from paying interest.
If the RBI declares the bank’s point of non-viability, AT-1 bonds can be written off entirely to improve the position of the bank.
In case a bank goes under, at the time of liquidation the prioritization of repayment would be as follows:
1.Deposits
2.Tier 2 bonds
3.Additional Tier 1 Bonds
Tier 2 Bonds
Basel 3 Tier 2 Bonds are supplementary to Tier 1 Bonds. It provides an extra layer of protection to investors by way of loss absorption features in Tier 1 Bonds. They consist of subordinated debt. Since they’re non- perpetual neither a call nor a put option is available.
Pros:
They come with an original maturity of 5 years and are redeemable.
In case the bank goes under liquidation, repayment of Tier 2 bonds is given preference over Tier 1 bonds.
In line with lower risks involved, they are rated a notch or two higher than Tier 1 bonds.
No lock in clause for payment of interest.
Risk Associated with Tier 2 Bonds:
They can be written off or converted into common equity upon declaration of Point of Non-Viability by the RBI.
Lower interest rates than Tier 1 bonds.